The Secret Law of the Markets

(Boris Schlossberg and Kathy Lien, two of the leading experts on foreign-currency trading and other investments, join the Money and Markets Afternoon Edition team. Once a week, we will present their financial insight after the day’s market close. Today, Boris Schlossberg gets us started.)

Market Roundup

Dow

16,899.32 (+34.24)

S&P

1,986.45 (+8.10)

NASDAQ

4,703.42 (+13.83)

10-YR Yield

1.85% (+0.01)

Gold

$1,241.00 (+$10.20)

Oil

$36.33 (+$0.18)

In one of the best investment columns written this year — titled “How to Make Volatility Your B****” — Josh Brown goes through the step-by-step process of dollar-cost averaging, demonstrating why it is the single greatest investment strategy ever created.

Dollar-cost averaging is simple: buying a set dollar amount of an investment on a regular schedule, regardless of the price. Brown shows how this consistent and steady buying of an equity index will beat any hedge-fund return anywhere, anytime.

The idea is that some of your capital will have massive double-digit returns as you scoop up assets at fire-sale prices. Some of your capital will have average returns, and some of the capital may even have negative returns as you pay up during market rallies, but the overall value of your holdings will almost certainly rise over any 10-year period.

One investment strategy stands out above the rest.

The only way that this strategy would fail is if stocks slowly but surely drifted to zero over a 10-year period, in which case you probably would have much bigger issues to worry about. As long as equities have an upward drift, you simply can’t do better as an investor than dollar-cost averaging into the index.

The dollar-cost averaging strategy of success relies on two factors — the natural upward drift of equity markets and the much more important idea of the law of large numbers.

The law of large numbers simply says that outcomes will almost always reach their expected end, as long as you have enough samples. For example, if you flipped a quarter three times in a row, chances are good that you could get all heads or all tails. In fact, 12% of the time that’s exactly what would happen.

Does that mean that the coin is rigged? No. It just means your sample size is very small and highly biased. Flip the same coin 1,000 times and the probability that heads or tails will fall within a few basis points of 50% are almost assured. Do it 10,000 times and they are practically guaranteed.

“The underlying concept behind the law is that you need to trade SMALL.”

The law of large numbers is an amazing principle. It essentially tells you all you need to know about how to get rich. Just chop up risk into tiny little pieces and take many (hundreds or even thousands) samples of that risk, and over time you will be much wealthier than you are now.

Of course, this little mind experiment assumes that the risk you consider is actually worthy. For example, if you dollar-cost averaged gold for the past 50 years, you would still be worth a lot of money (if for no other reason than you would own a lot of gold!) but not nearly as much money as if you had bought the S&P 500. Still even in that example, you can see the power of this principle in action.

That’s why it always amazes me that traders routinely ignore this foundational idea of risk control. In fact, I think the primary reason why most traders lose money in the market is that they don’t appreciate the power of the law of large numbers.

The underlying concept behind the law is that you need to trade SMALL. There is actually some poetic irony in that dynamic. You need to do a lot of trades in order to assure yourself of long-term success, and the reason you need to trade small is precisely because you need to be able to withstand the bad runs that will inevitably occur.

The first thing that I do in order to improve a trader’s performance is to make them trade so small that it seems almost miniscule.

Frankly it almost doesn’t matter what system they trade; reducing size has an instant and dramatic impact on performance. They stop panicking and execute the strategies much more effectively.

Marry the law of large numbers with a sound trading algorithm and you have nearly a fool-proof recipe for success. Don’t believe me? Look at high-frequency firms, like Virtu Financial (VIRT), which trade millions of shares per day, 100 shares at a time, and haven’t had losing days in years. As an individual trader, you don’t need to mimic the hyperkinetic pace of HFT shops, but you do need to slice risk into tiny increments just like they do.

It’s truly unbelievable that the answer to 90% of our trading problems lies in size rather than strategy, yet so few traders take advantage of the key law that governs the markets.

Happy trading!

Boris Schlossberg

P.S. We have confirmation that we’ll get the green light for two explosive new “Buy” signals THIS WEEK …

All we know for sure is that these exciting trades will be activated NO LATER than Friday …

And when these two signals go out to our members, two things will happen:

1. If you have not yet activated your membership in Global Currency Investor, you will miss out on the opportunity to join us as we go for gains of up to 963% on these two trades, and …

2. You will have missed your opportunity to SAVE $2,400 on your Introductory Membership!

CLICK THIS LINK for details on Global Currency Investor — and activate your membership while there’s still time to make sure you receive these “Buy” signals the minute we release them!

Other Developments of the Day

Astronaut Scott Kelly returned to Earth after 11 months in space with Russian colleague Mikhail Kornienko, having traveled some 144 million miles in space. He also made 5,440 trips around the globe in his 340-day journey. When he blasted off in March of last year, Scott Walker and Jeb Bush were considered the GOP’s leading presidential candidates and Donald Trump was known as a reality TV show. Few people outside of Vermont had heard of Bernie Sanders. The price of oil at that time? About $50 a barrel. The mission was to test Kelly for the long-term effects of living in space. Kelly took his own blood samples and performed other tests — the results will be compared to those from his twin brother, Mark, a retired astronaut who remained on Earth.

Forbes magazine has released its World’s Billionaires List for the year, with the total net worth of the 1,810 people listed nearing $6.5 trillion. The richest person in the world, with a net worth of $75 billion, was Microsoft co-founder Bill Gates. But it’s not all good news for Gates – his net worth actually declined in the year from $79.2 billion. Poor guy. The list can be found here.

Retailer Sports Authority filed to reorganize its debt and operations under Chapter 11 bankruptcy. The company said it had debts exceeding $1 billion. It identified 140 stores and two distribution centers it would close in the coming months to streamline its operations.

The Money and Markets team

Boris Schlossberg is a weekly contributor to CNBC’s Squawk Box and a regular commentator for CNBC Asia and CNBC Europe. His daily currency research is quoted by Reuters, Dow Jones, Bloomberg and Agence France Presse newswires and appears in numerous business publications and newspapers worldwide.
Mr. Schlossberg has written articles on trading for SFO magazine, Active Trader and Technical Analysis of Stocks and Commodities. He is the author of Technical Analysis of the Currency Market and Millionaire Traders: How Everyday People Beat Wall Street at its Own Game, both of which are published by Wiley.
Boris’ extensive experience in trading and developing momentum-based techniques provide the foundation for BKForex’s strategies.

{14 comments }

billWednesday, March 2, 2016 at 6:09 pm

Great article Boris!

CynthiaWednesday, March 2, 2016 at 6:26 pm

So happy to receive your messages in writing Easier. Thanks

MuleWednesday, March 2, 2016 at 11:14 pm

If they don’t cut it out we’ll tell Trump on em …..(<:

Mule

MuleWednesday, March 2, 2016 at 11:21 pm

Sad news about Aubrey McClendon, RIP. Prayers for his family.

Mule

JimWednesday, March 2, 2016 at 11:48 pm

Symbolic of what’s happening to the U.S. Shale Industry. A flood of ficticious capital, creative accounting, and financing created an industry that was never cash flow positive and never will be. A third of the producers won’t make it through the year and 2017 will be a disaster as hedges expire. They need $130 a barrel to make it, which means somebody somewhere is losing $100 for every barrel produced. David Stockman’s description of Janet Yellin as a “delusional simpleton” was correct after all. There is simply no foundation for believing a continuos credit expansion can achieve real prosperity. Jim

GordonThursday, March 3, 2016 at 12:39 am

Jim
Your right of course especially about the part of fictitious capital and creative accounting. Yes it has given the USA a short term energy breather but companies jumping into this venture were careless to say the least. They were thinking with their wallets and not their brain. They knew by all jumping in at once they would yes create cheap fuel for America but they also realized that by flooding the market with surplus oil the market would tank and they would be in trouble. Even with my grade 10 education I could see that coming. They also knew that these wells depleted at a much faster rate than normal so to continue they would have to turn the USA into one giant Swiss cheese and in the process people’s health has been harmed. They rushed into the compressed gas market as well spending billions to set up terminals along the coast and now with these plants ready to ship gas the market has also tanked. Common sense has flown out the window replaced by rampant greed. What will be left for future generations?

JimThursday, March 3, 2016 at 12:46 am

Don’t sell yourself short. You are one of the very few that gets it. Jim

GordonThursday, March 3, 2016 at 12:46 am

I am rather amazed that the US job numbers came out last night here in Asia at 214,000 yet no mention has been made of them here today. I am also amazed at the number itself as where are these jobs located. All I see in the news is layoffs more layoffs stores closing consumer shopping dropping. Are McDonalds and BurgerKing hiring all these people. There sure seems to be a big disconnect between government numbers and what is happening in the heartland but then we have all learned by now not to trust government numbers have we not? Right after the numbers were posted the stock market did a little blip upwards. I was surprised it did not jump higher after all these are good numbers are they not? Maybe the market has truly had a reality check and has stopped rising on good and bad news.

JimThursday, March 3, 2016 at 12:58 am

The Bureau of Labor Statistics may be the most dishonest agency in government. False employees don’t pay withholding. That withholding receipts are already at recession levels. The truth is out there, you just have to know where to look. You don’t see anybody else raising rates. The world knows the Fed is full of baloney too. Jim

Eagle495Thursday, March 3, 2016 at 9:38 am

Jim and Gordon,
Basic economics told us that when old Dick pulled that hat trick that took oil from$18 to $140 there would be, in short order, an oversupply…… Add that to the second Stock Market Crash and Depression in the past 100 years along with NAFTA and GATT that made the 3% wealthy, but gutted American Industry and Middle Class Labor and naturally we have a HUGE problem….. Now all we need are some honest politicians who have not sold out to the gold coin of the 3% and we can start straightening out this mess…… See any of those on the horizon, thanks to Citizens United?

Lifestudent38Thursday, March 3, 2016 at 3:08 am

If you have a sound strategy written in a concise trade plan, and fully adhering to that plan, then the law of large numbers will work in your favor. If not, then the law of large numbers will work against you, slowly (or fast depending on how risk management principals applied) eroding your trading account until the sharks have taken it all.

$1,000 goldThursday, March 3, 2016 at 9:39 am

of course brokers love this strategy and couldn’t care less that dollar cost averaging has been proven a sucker’s game long ago

Newbie (@humblenewbie)Saturday, March 5, 2016 at 12:27 pm

Hi Boris, I’m interested in your money management service and send two inquiries about it via your website months ago. I wonder if I should continue to wait for your reply — or do you ever reply to such inquiries? is there customer service available for managed accounts in your company? Hopefully you’ll read this message. Nice weekend!

Could other friends here who use BK’s money management tell me how it’s doing? Many thanks!